Business Valuation Fundamentals
An Overview of Several Methodologies for Valuing Businesses.
Even though some of the largest cases that attorneys handle involve valuing an entire business, very few attorneys can intelligently discuss business valuation. The subject is not a part of a typical law school curriculum. Consequently, many attorneys and others feel that appraising a business and appraising a piece of real estate (a process with which most people in the business world are familiar) are the same process. The truth is that there are a few very basic overlapping theories of value, but few similarities beyond that.
Methods for Valuing Businesses
There are many methods for valuing a business due to (1) the unique nature of each business, and (2) the purpose of the valuation. Here is a rundown of a baker's dozen of the most common approaches to value:
Market Comparison Approach - Compares the market value of the subject business with that of similar businesses. While this may seem similar to the market data approach used in real estate valuation, the business valuation process is much more difficult since there is no common yardstick for measurement, such as dollars per apartment unit or dollars per square foot of rentable office building, shopping center, or warehouse space. Instead, you only have the equity (net worth) of the businesses, and the concomitant problems of variations in levels of equity, relative size of the businesses, locational and market differences, differences in the level and quality of services or products offered, and other unique features of each business that require prudent adjustments in order to result in meaningful value numbers.
Replacement Value Approach - Measures value by determining what it would cost to replace the assets and business processes used by the business today. Differs from the Market Comparison Approach in that this approach deals with acquiring the parts that make up the whole business rather than looking at prices for the entire business, as does the Market Comparison. Often used in settling insurance claims.
Future Net Operating Income Approach - Uses the present value of reasonable future net operating income. Useful for a prospective purchaser whose chief interest is the business's future net income. Due to the speculative nature of this approach, great attention must be given to the bases for the projections of future revenues and expenses. Likewise, the rate at which those future earnings are discounted to a present value must be sound.
Historical Net Operating Income Approach - Takes the actual net income figures for the last few years and capitalizes them into a value figure. Any factors that caused any year to have higher or lower than typical earnings must be considered and adjusted.
Going-Concern Value - Basically the value of a company as an operating entity. Often used in conjunction with other approaches in order to determine a residual goodwill amount (i.e., organizational value). Often used in income tax valuation situations.
Enterprise Value - The theoretical takeover price. In the event of a buyout, an acquirer would have to take on the company's debt, but would pocket its cash. The value of a firm's debt, for example, would need to be paid by the buyer when taking over a company, and thus Enterprise Value provides a much more accurate takeover valuation because it includes debt in its value calculation.
Liquidation Approach - The reasonable prices for the various assets or business entities that make up the business are calculated and totaled. Assumes that the master entity is ceasing to carry on business and is selling its parts in the most advantageous manner. Often applied to businesses that have a strong underlying asset value but a poor earnings performance record.
Formula Approach - Earnings, dividends, and book value are considered in this approach and weighted in accordance to their appropriateness to the particular company under consideration and their importance to the acquirer.
Capitalization of Dividends Approach - Looks upon an acquisition more as an acquisition of an investment security that will be held indefinitely. While it is a unique and limited approach, it is appropriate for some circumstances, and can be used as an indicator of value for consideration in some difficult evaluation cases.
Debt-Free Approach - Permits an analysis of the company's operations without consideration to the present debt structure. Allows a prospective purchaser who might acquire the business and pay off the existing debt to see what the business might be worth under those circumstances.
Reconstructed Capital Structure Approach - Similar to the Debt-Free Approach, this methodology allows a prospective purchaser to see what a company would be worth with different capital and debt structures. Typically, several competing debt and equity structures will be examined and compared.
Capitalization of Future Cash Flow Approach - When there are large non-cash deductions from income and when the owner or acquirer is more interested in long- term growth of his or her investment, this approach might be more meaningful than the capitalization of past or anticipated net income.
Capitalization of Historical Cash Flow Approach - Actual cash flows over the most recent years are capitalized. Assumes that the business will continue to operate in the future as it has in the past.
Adjusted Book Value Approach - Starts with the company's most recent financial statement. Then the values of the assets and liabilities are adjusted to reflect current values rather than historical values that may be inaccurate from a market value stand-point due to depreciation deductions, increases in asset value, collectability, payment terms, etc.
Tax Value Approach - In valuing a business's taxable real and personal properties for ad valorem tax purposes, it is typical to rely more heavily upon the assessed values of other similar properties than you would otherwise consider. Real estate is part of a business, but generally is not valued separately - except in special circumstances, such as where a business has excess real estate that has a significant market value and is capable of being sold separately without negatively impacting the remaining operations of the business.
How Not to Value A Business
Financial Statements - Do not rely on the stockholders' equity or net worth figure on the company's financial statements. They are only useful as a starting point. Some assets, such as real estate, are probably carried at depreciated values that are lower than their market value. The financial statement may contain some intangible assets that are incapable of being sold separately.
Spreadsheet and Mathematical Models - Do not use a comparative spreadsheet model, or an economic consultant that relies on one. Many analysts (MBAs are notorious for this) think that they can simply develop a clever spreadsheet model, insert the appropriate inputs, and voila, a value figure pops out like a piece of toast. This weak methodology does not allow for the many differences that probably exist between the subject and the companies used as a basis for setting up the comparative spreadsheet.
In-House Hired Help - If the valuation issue with which you are dealing could possibly go to trial, do not use an in-house person from the company or bank as your expert. You will never convince a jury that the person has any objectivity or would be capable of voicing any opinion that was contrary to the interest of his or her employer. Spend the few bucks it will take to obtain a credible estimate of value.
CPAs - Do not use a CPA to value a business. Their service is accounting, which is basically making sure that numbers track and go in the right places. This is totally different from determining value. It just so happens that the financial statements that they produce have a net worth figure, but it was explained supra that these figures cannot be relied upon as meaningful indicators of value until they have been subjected to numerous adjustments that are beyond the scope of a CPA.
ABOUT THE AUTHOR: Don Coker
Don Coker provides expert witness and consulting services. Over 400 cases for plaintiffs and defendants nationwide, over 100 testimonies, and 12 courthouse settlements in all areas of banking and finance. Listed in the databases of recommended expert witness consultants of both the DRI and the AAJ. Clients have included numerous individuals, 60 banks, and governmental clients such as the IRS, FDIC.
Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, Guaranty Bank, and a 2-year stint as a high-level governmental financial institution regulator.
Holds a B.A. degree from the University of Alabama, completed postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School.
Copyright Don Coker
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.